Is It Better to Take a $150,000 Lump Sum or $1,200 Monthly Pension Payments?

When companies offer a pension , it's common to give retirees two options: collect the pension as a lifetime monthly payment or receive it as a lump sum at retirement.

Monthly payments over time are the format that most people associate with pensions. However, a lump sum payment can, sometimes, be the better option. Depending on what your company offers and what kind of returns you can pursue, you might collect more from your money in the long run by taking it all up front.

For example, say that you're an individual getting ready for retirement. Your employer has offered you either a $150,000 lump sum or $1,200 monthly payments for life. Here's how to think about it.

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Pensions are otherwise known as "defined benefit retirement plans." This means that your employer commits to providing certain benefits in retirement. This is as opposed to "defined contribution retirement plans," through which your employer commits to providing certain contributions during employment.

With a pension, your employer promises to provide monthly payments throughout your retirement. The exact amount can range widely, and is typically determined by factors that include your age, salary history, tenure with the company and seniority at retirement. This amount may be indexed to inflation or, like an annuity, it might be fixed.

It is the employer's responsibility to keep the pension funded and solvent throughout eligible former employees' lifetimes. To ensure that this system functions, pensions are backstopped by a federal agency which insures pensions up to a maximum amount.

Pensions are popular among workers and retirees because of their reliability. You don't have to worry about balancing savings against costs of living. Nor do you need to manage complex, unpredictable and (if, you go it alone, very mixed ) market returns. Instead, you can simply retire with an income.

For this same reason, however, pensions have become unpopular among employers. The same reliability that makes pensions valuable for retirees creates high and indefinite costs for companies. The expense of caring for a former workforce, quite simply, is very expensive.

As a result, among employers that do offer a pension, it's common to offer " lump sum distributions ." With a lump sum distribution, the employee receives a single payout at retirement instead of monthly payments for life. This can turn an indefinite series of payments into one, scheduled expense, which is much more manageable for the employer.

For example, say that your employer has offered you two options. You can take $1,200 per month for the rest of your life, or you can collect a $150,000 lump sum payout. Which should you take?

The answer here depends on a lot of factors, including how the math breaks down.

If you are seeking reliability, take the monthly payment. As discussed below, under the right circumstances you might get more money from the lump sum payment, but that will depend on market returns and there's an element of risk to any investments. If you take the monthly pension, your payments are mostly secure and your budgeting and investing needs may be simpler.

If, instead, you're trying to maximize your retirement income the right choice will depend a lot on your assumptions and your projected investment outcomes.

An investor looking for safer investments, generally in the bond market, will probably make more money taking the monthly payments. However an investor who can successfully manage a more aggressive position, perhaps with a mixed portfolio or an S&P 500 index fund, will probably make more with the lump sum.

To understand this, let's assume that you retire at age 67 and have the average life expectancy of around 85. And let's assume that your pension is fixed, with no inflation adjustments. Using Schwab's pension calculator, you would need to invest your $150,000 at a 7.03% rate of return just to match the income of your $1,200 monthly payments over your life expectancy.

This means that you would need a reliable return of around 8% in order to make the lump sum payment meaningfully more valuable than the monthly payments and still be able to use some it in the meantime. This is certainly possible. In fact, 8% is about in line with the average return on a mixed bond/equities portfolio. And if you have the flexibility to manage volatility, you could do even better with a pure S&P 500 fund's average 10% to 11% returns.